Private lenders function similarly to hard money lenders. They provide short-term loans for house flippers and make money on interests.
If you stay in real estate long enough, you’ll likely work with a private money lender eventually. But, for new investors, it’s not always clear what private lenders do. More precisely, how do private lenders make money?
Private lenders function similarly to hard money lenders. They provide alternative financing to real estate investors. Typically, they offer short-term loans to house flippers. Private lenders make money in two ways: 1) origination fees and 2) interest on the loan balances.
WHAT IS A PRIVATE LENDER?
To explain how private lenders make money, I first need to outline what a private lender does. In basic terms, private lenders are individuals who A) have extra cash and B) want to lend that cash to other investors and make money on the interest. Private lenders serve as an alternative financing source for real estate investors. In situations where conventional lenders (e.g., banks and credit unions) won’t issue a loan, private lenders often will.
While private lenders provide a variety of loans, they typically lend to real estate investors—frequently fix & flip investors. With a conventional mortgage, you generally cannot purchase a distressed property needing repairs. This means that traditional mortgages don’t work for house flippers, as they inherently buy properties in need of repair.
On the other hand, private lenders base their loans on what a property will become. Rather than establishing a loan on a property’s “as-is” value—like a conventional mortgage—private lenders loan against a property’s appraised after-rehab value, or ARV.
Private lenders provide real estate investors with three primary advantages:
- Speed: Conventional mortgages typically take 30 to 45 days (or more) to close. Investors can close a loan with a private lender in less than a week. This provides tremendous flexibility when taking advantage of new deals in competitive markets.
- Home condition: As stated, private lenders will issue loans for distressed properties. While each private lender varies, many lend up to 70% loan-to-value based on the property’s ARV. This means that house flippers can finance deals instead of needing to pay all cash.
- Lower credit requirements: Private lenders concern themselves more with the deal than the borrower’s credit profile. As a result, most will work with real estate investors who don’t have great credit. In general, the credit requirements for a private lender will be A) lower and B) more flexible than a conventional lender’s requirements. However, having judgments or bankruptcies in your credit history will likely prevent you from securing a private loan.
Before issuing a loan, private lenders typically want to see equity in the property. This demonstrates that the investor has some “skin in the game” and will complete the renovation. Related to this, private lenders generally require borrowers to have actual real estate investing experience. They don’t want to lend to a first-time house flipper who may or may not successfully renovate and sell a property.
HOW DO PRIVATE LENDERS MAKE MONEY?
Broadly speaking, private lenders make money in two ways:
- Origination fees: These are the fees a private lender charges to originate, or put together, a loan. Depending on the lender, these fees can be charged as 1) a flat fee, 2) a percentage of the loan amount or 3) a combination of these options. Loan originations take time and administrative effort, and private lenders require compensation for this work.
- Loan interest: This is what private lenders charge for letting borrowers use their money. In conceptual terms, interest is how private lenders are compensated for their risk by lending money. Private lenders assume greater risk than conventional mortgage lenders because private loans are secured by properties that still need to be renovated. If a borrower defaults before completing the rehab, private lenders must foreclose on a partially-rehabbed property. Due to this increased risk, private lenders charge higher interest rates than conventional lenders.
Related to interest, private loans also tend to have shorter terms. They exist to finance fix & flip deals—not long-term investment property purchases. Most private loan terms range from one- to three years, depending on the particular deal. This shorter time horizon also justifies the higher interest rate private lenders charge. They have less time to earn income, so they need to charge higher interest rates to justify the risk.
PRIVATE LENDER VERSUS HARD MONEY LENDER
If you know anything about hard money lenders, the description of private lenders likely sounded familiar. They provide alternative financing to real estate investors, frequently for house flip deals. Both lenders make money through loan origination fees and loan interest.
Private lenders differ from hard money lenders in terms of organizational structure. Private
lenders are individuals. On the other hand, hard money lenders have established companies.
These organizational differences lead to some key advantages for hard money lenders over private lenders:
- Established systems and support: Hard money lenders have established business processes and administrative support as a formal company. These characteristics mean you’ll likely have a far more reliable partner in a hard money lender over a private lender. For instance, if you have a question about your repayment schedule, what happens if the private lender is on vacation? With a hard money lender, you’ll have the customer support of an actual business—not just a single person.
- Experience: As a business, hard money lenders deal with real estate loans daily. This gives them a tremendous amount of experience, and they can translate this experience into direct assistance for their borrowers. Conversely, private lenders may have little to no expertise in issuing these sorts of loans, meaning they won’t provide you with a guaranteed level of advice and assistance.
- Reliability: Private lenders are more likely to flake out of deals than an established hard money lender. My private lender failed to show up at the closing and stopped answering calls. Fortunately, I had a solid relationship with a hard money lender who was able to move in and close the deal.
HOW TO BECOME A PRIVATE LENDER
Advantages exist to private lending. You profit from real estate deals without the hassle of fix & flip work. You screen borrowers, lend money, sit back, and make money.
Before diving into private lending, you’ll need:
- Cash: It should be obvious, but you can’t be a private lender if you don’t have a bunch of money sitting around to lend.
- Experience: While private lenders may not do the rehabs, they need to know everything about these deals. They need to intimately understand real estate risk, valuations, contractor bid processes, lending legal requirements, administering loans, and more.